Value investors love a bargain. The entire idea of value investing is to buy something below its real price. But sometimes, the price is low for a good reason and never recovers. This is commonly called a “value trap.”

What Are Value Traps?

Value traps emerge when a stock looks cheap at first glance. The company may have unusually low valuation ratios, like P/E, price-to-sales, or price-to-book value. The problem is that later on, this low price becomes perfectly logical in face of declining business and earnings.

There are many reasons why a company that looks like a bargain turns out to be not a good deal. What they all have in common is a stock that never recovers or keeps declining even after it was judged “cheap” by value investors.

The problem with value traps is that they are only obvious with hindsight. By definition, good value stocks will share a lot in common with value traps. They seem cheap, they are out of favor among investors, and they usually have some bad news attached, justifying the current low prices.

How to Spot Value Traps

So how can you spot a value trap? The first thing is to understand that while good value stocks and value traps might share common quantitative metrics, they are very different from a qualitative point of view.

High-quality stocks with a temporarily depressed price will recover. Bad stocks with problems in the underlying business often keep getting worse.

🚩 Here are some of the qualitative characteristics that might indicate a stock is actually a value trap:

Peak cycle: This is common in cyclical industries, like commodities, for example. High earnings might indicate the top of a cycle. From there, earnings will decline, and multiples will contract. This is a good way to have a stock price crashing by anywhere from 50%-90% simply out of cyclicality.
Changing competitive situation: Looking at previous periods, the stock might seems cheap. It may have recently lost its competitive advantage, or its segment has fundamentally changed. Current earnings might just keep getting worse, with no end in sight.
Hidden costs: Is the company reporting its real risk exposure honestly? This can happen with financials. For example, a bank may make loans that are not as safe as advertised. This is the kind of thing that happened in 2008 and led to the collapse of Lehman Brothers. Another example would be large pension costs not properly reported in the balance sheet.
Hidden liabilities: This can be a problem for tech or industrial and chemical companies. Legal risks like lawsuits for causing cancer or losing a key patent are hidden liabilities as well. Investors in Monsanto/Bayer have lost a lot of money by neglecting this risk.
Out-of-financial metrics risks: Maybe earnings are not as safe as they look. Is the company operating in a corrupt country? Then the price might reflect the risk of nationalization. Or maybe the majority shareholders do not respect minority shareholders’ interests.
Are cash flow and earnings temporarily inflated? Maybe the company got a lot of cash this quarter from selling a part of the business. This might make the ratio looks good now, but it will not happen again. Did some event in the world push profitability up temporarily? A perfect example was the Covid pandemic, where some explosive growth for e-commerce and work-from-home stocks was never going to be sustainable for a longer timeframe.

The Thin Line Between Value and Value Traps

Looking at the list above, it might seem that protection from value traps is simple. Due diligence should be enough to spot hidden risks. But the truth is that most of these risks are usually discussed openly as the reason for the cheap price.

A good value investor is someone able to identify when the perceived risks are higher than the real ones. This is very subjective.

For example, the peak cycle issue might be happening. Or are there still 2-3 years left in this cycle? Which one is it? Getting the answer right can be the difference between a value trap and having spotted a 10-bagger (stock going up 10x).

Similarly, a jurisdiction risk might be exaggerated. Or not. A recent example was given to us with Russian stocks. Many value investors suffered considerable losses buying Russian stocks that were objectively very cheap. Then their value went to essentially zero if you are a Western investor due to sanctions.

The Russian example is very instructive.

Daring value investors betting on the country in the 1990s are hailed as visionary geniuses, with returns often in the 10x-100x in a decade or two.

Investors in Russian stocks in 2022 are mocked for their lack of insight.

I would argue that luck, more than skill or insight, is likely the difference between the 1990s and 2022 Russian stock investors.

What about Chinese stocks? Brazilians? Indonesians? Indians? Which are too risky and which are a bargain?

Predicting the future is hard, and price fluctuations and hindsight make people think of themselves as smarter than they are.

How to Survive Value Traps

A low price can be an opportunity. It can also be a warning sign: maybe the market sees something that you don’t.

Because value investors disagree with the broader market, they are doomed to stumble on value traps every so often. Even the best will get it wrong sometimes. So how do we solve this dilemma?

To me, the answer is in portfolio construction, asymmetry, mental flexibility, and skepticism.

Portfolio Management

The first component here will be diversification. A portfolio should not be an all-in bet on 1-3 stocks or just one theme. Of course, concentration might bring outstanding results, but it might also bring complete ruin. Only with hindsight will you know which one it is.

The important part is also to diversify the possible traps. So all possible types of diversification need to be done in parallel. Different countries, industries, company sizes, business models, and technology.

In appearance, this runs contrary to the “circle of competence” principle. I would argue that even with a narrow circle of competence, there is still plenty of options to diversify. Even if ultimately, a wider range of knowledge and experience, leading to a larger circle of competence, will be the best tool to keep diversifying.

Asymmetry

When looking at total returns, we look at the average of ALL returns. This means that if you put out 10 bets, and nine resulted in 100% losses, but one yielded 10x, you are even. If two yielded 10x, you are 10x up.

So an important part is to get the upside as open as possible and the downside as limited as possible. I would recommend reading Nassim Taleb on this idea, and more specifically, his book Skin in the Game: The Hidden Asymmetries in Daily Life, to understand further the concept of asymmetry in both investing and society.

Staying Flexible

Another factor is the ability to admit that you were wrong.

This was a central investing tenet of the legendary George Soros. He is famous for making billion-dollar bets, then giving up on them a month later when he changed his mind.

Most value traps don’t close on their victim suddenly like a bear trap. They are most often than not the result of a slow decline that never stops, akin to a slow-moving boa constrictor.

Admitting you are wrong is spotting the value trap. Getting out early is what will save you. Discipline, stop-loss orders, or the ability to see what you got wrong are vital survival tools.

I am only rich because I know when I’m wrong.
George Soros

Skepticism

It’s exciting to spot what seems to be an overlooked value stock. A ticker pops up on your screener, you look through the ratios, and for a moment, it seems like you’ve found the value investor’s holy grail: the stock everyone else has overlooked.

Before you rush out and buy, think twice. Either you have spotted something the entire market has missed, or the market sees something you don’t. Which is more likely?

Undervalued stocks do exist, but it’s extremely rare to find one that is radically or dramatically undervalued. If there’s a really large disparity between price and apparent value, it’s very likely that there’s something in the picture that you’re not seeing. Remember the old saying: if it seems too good to be true, it’s probably not true.

Conclusion

Value traps are something investors should be very wary of. At the same time, investors must recognize that almost all of them will fall into a value trap at some point in the future.

I will go as far as saying a value investor who does not have a good war story about a value trap is not a seasoned investor.

There’s no silver bullet that will protect you from value traps. Instead, reducing the damages they cause will rely on the whole toolkit available to investors: experience, deep knowledge of a sector, macro and micro analyses, accurate financial forecasts, mental flexibility, managing asymmetries, portfolio construction, and simple skepticism.

So the question is not, “Is it a value trap,” But more something around “How can I realize it early if it is a value trap, and then what can I do?”

Value traps are a part of life for investors, especially value investors. Learning to survive stepping on one is what will make a portfolio successful in the long run.

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This article originally appeared on FinMasters.com: Value Traps: What Are They and How to Avoid Them

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